Eurozone Braces for Economic Storm

Anatole Kaletsky, Times of London April 9, 2009

If you think Alistair Darling faces trouble in his Budget, spare a thought for Brian Lenihan, the Irish Republic's Finance Minister, who on Tuesday announced his second emergency budget in six months, imposing drastic tax rises, pension and wage cuts, still leaving his country with the by far the biggest budget deficit in the eurozone.

Or for Yannis Papathanassiou, his Greek counterpart. His country's credit has been downgraded to one notch above junk status and was justifiably described yesterday as teetering on the verge of bankruptcy in the German magazine Stern.

Or for Pedro Solbes, the respected Spanish Finance Minister, who was sacked on Monday in response to the meltdown of an economy and banking system said to be invulnerable only a few months ago.

Or even for Peer Steinbrück, the German Finance Minister, who, despite his swaggering boasts about the triumph of the Rhenish social-market model over Anglo-Saxon capitalism, presides over the weakest leading economy in the world outside Japan.

Europe, even more than America or Britain, is caught in the global financial storm and if the world suffers another blow in the months ahead, comparable to the collapse of Lehman Brothers, it is most likely to involve a crisis in the eurozone. Is it possible that Europe, whose biggest economies - Germany, France and Italy - never experienced an Anglo-Saxon style housing and credit boom, will suffer more damage than Britain or the US?

This seems so unfair that many supposedly unsentimental politicians, businessmen and financiers refuse to believe it. But such childish moralising has never driven international financial markets.

Economic performance should be assessed objectively, without all the talk of sin and retribution so popular at present. The eurozone faces three threats more serious than any in the US or Britain: the extreme vulnerability of Germany's economy to collapsing exports, financial instability in Eastern Europe and the growing tensions between the core and the periphery of the eurozone.

The ominous possibility is that, between now and the German general election on September 27, these three separate, but mutually reinforcing, dangers could combine into a perfect storm.

The recession has hit Germany much worse than any other big economy save Japan. Its GDP plunged at an annualised rate of 8.2 per cent in the fourth quarter, compared with a 6 per cent decline in Britain. The OECD projects a further decline in Germany of 9.6 per cent in the first quarter, compared with 5.4 per cent in Britain. In 2009 as a whole, the German economy is expected to contract by 5.3 per cent, compared with Britain's 3.7 per cent. Germany is expected to have the highest unemployment in the G7 by 2010, while Britain would have the lowest outside Japan.

Germany's focus on exports has turned out to be a weakness. Its cars and investment goods have suffered even more from the recession than financial services and other knowledge-based products. The strength of the euro has damaged its competitiveness and Germany's fastest-growing export markets have been the booming countries on the periphery of Europe - Spain, Ireland, Central Europe and Russia - all of which have now collapsed.

Germany has found itself just as exposed to boom and bust as Britain or America. The key difference is that it relied on property and credit booms in countries such as Spain, Hungary, Russia, Ireland, Scandinavia - and Britain - over which it had no control.

This brings us to Europe's second problem: the financial meltdown in Eastern and Central Europe. In the past ten years Hungary, Romania, Bulgaria and the Baltic states have run up foreign borrowings much larger in relation to their national incomes than Thailand, Indonesia and other Asian countries that defaulted in the 1990s.

To make matters worse, a much higher proportion of these loans have been in foreign currencies - 70 per cent of the mortgages and car loans in Hungary are in euros or Swiss francs. Thus a sharp rise in the euro against local currencies would drive many households and businesses into bankruptcy. For this reason, Central European governments have desperately tried to defend their currencies, seeking IMF support and reacting joyfully to the increase in IMF resources agreed last week by the G20.

But experience suggests that currency defences based on IMF programmes rarely succeed. Indeed, the IMF normally forces borrowers to devalue their currencies, as it did in the case of every leading Asian and Latin American country. It is hard to see why China, India and Brazil, with their growing influence on the IMF, should agree to radically different rules for European borrowers.

Which brings us to Europe's third vulnerability: tensions in the eurozone. While financial conditions in Central Europe today are generally worse than in Asia in the 1990s, the Europeans have one immense advantage. They can rely on a rich uncle - the German taxpayer. There was never a chance of Japan or China bailing out Thailand, South Korea and Indonesia, but it is assumed that the EU - ultimately the German taxpayer - will stand behind the debts of Central Europe.

The problem with this comforting assumption is that a financial crisis in central Europe and Austria would greatly aggravate tensions already obvious in the eurozone. The Irish, Greek and Portuguese economies are in freefall as a result of collapsing housing markets, aggravated by the expensive euro's impact on exports and tourism. Spain looks increasingly vulnerable for the same reasons. As Alan Brown, of Schroders, noted in a recent study, prices in these four peripheral euro-members have risen 18 per cent relative to Germany since 1999.

If Germany bailed out Austria and Central Europe, it could scarcely deny support to the Irish, Greek and Portuguese governments - or later Spain and the true colossus of European sovereign borrowing, the Italian Government.

With German unemployment and budget deficits rising to previously unimagined levels, political support for a pan-European financial bailout might be hard to muster, especially in a bitterly contested election.

Despite this, an existential crisis of the eurozone remains unlikely. In extremis, Germany would almost certainly offer support. But suppose an emergency package had to be organised over a single weekend in response to a European crisis. Is it obvious that the EU and Germany would cope any better than the US Government did in the Lehman collapse last September?

That is a question nobody seems to be asking - which probably makes it the biggest risk facing the global economy today.

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C Chapman in Italy, i think you may have missed the point of this article. Europe is essentially proped up by German EU taxes- the main benefactor of which- is Italy. Should Germany withdraw from the EU because of the cost of bankrolling lame ecomomies, those countires could be in deep trouble.

Daniel, London,

Perhaps the most alarming possibility is that Germany uses the crisis to engineer effective German domination of the EU financial, political and bureaucratic systems - and who could blame them. Only the UK has the size and independence to counter this - 1939 all over again!

Ian, Stratford, UK

Cameron/C Chapman - Stop UK Bashing - Italy has always and will always be in a financial mess...It will never change. Germany and Japan are far harder hit by current problems than the UK..Spain is a disaster..there is NO property bubble here anymore - Just Like in Australia - record personal debt!

Stefan, brighton, UK

johnbowman, Sarlat, France

We Brits always smile

Paul, London,

I ive in Italy now, thank god, and look at events in the UK with the appalled horror of watching a railcrash. We have problems here yes but on nothing like the scale of UK. Cost of living here and quality of live is a million times better and people even look happy. When did you last see Brits smile

c chapman, corridonia, italy

If it so desires, Germany can cut itself adrift from the Euro. It has ample savings to be able to afford to start consuming internally. Head in the sand Britain meanwhile, is entirely reliant on borrowing from the kindness of strangers to keep its property bubble afloat, and food on the table.

cameron, sydney,

The basic problem with the EU is it's unstable political structure. Unlike the US it does not have a developed Federal/State government power structure.

P. Brooks, Palm Bay Florida, USA

No I wont spare a thought for them. I'll spare a thought (daily) for them because they have one advantage over us. They aren't ruled by Gordon Brown. Only mad people will vote Labour at the next election. I will sleep rough in a European country in preference to this ever-bigger mafia/state.

Andrew, Leeds,

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Anatole Kaletsky

Anatole Kaletsky writes for The Times Comment pages on Thursdays. One of the country's leading commentators on economics, he was formerly Economics Editor and is now Editor-at-large of The Times. He has won many awards for his financial and political journalism. Before joining The Times, he worked for 12 years on the Financial Times

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